The US Fed is Insolvent

Quite the headline yeah?  Right now it is technically true but you aren’t really seeing any headlines to this effect elsewhere despite this being both the world’s largest central bank and the custodian of the world’s reserve currency.  So why is that?

First let’s look at the setup.  Regular readers know that the US Federal Reserve, the Fed, embarked on an unprecedented monetary stimulus program during and post the GFC called Quantitative Easing (QE).  QE involved the Fed buying bonds off its member banks with freshly printed money and hence flooding the market with liquidity, reducing real interest rates, pumping financial markets and averting the GFC from becoming much worse.  They bought around $4.5 trillion worth and those bonds sit on their balance sheet as assets (ironic given they are debt bills, but let’s not get bogged down on such trifling matters…).   By them buying all those bonds they forced up the price which conversely lowers the yield.  Yields on US Treasuries are considered the world’s ‘risk free rate’ and baseline for interest rate calculations.  Problem solved.

However as part the Fed now being in tightening mode, they commenced QT (Quantitative Tightening) late last year, unwinding those holdings at a rate of $50b/month ostensibly until the end of 2020 (presuming no recession/crash in between).  That of course is to have the opposite effect of raising rates and hence lowering bond prices.  And the penny may just have dropped for you.

So the Fed holds over $4 trillion of bonds that they themselves are making worth less and less.  In their last quarterly (Q3) report they pegged that loss at $66.5 billion for the quarter.  That number, whilst undoubtedly big, takes on far bigger meaning when you consider that same report includes a balance sheet showing their total capital (assets less liabilities) at just $39.1 billion.  But that $39.1 billion has their bond assets at cost, not at current market (i.e. not marked to market like normal companies).  Therefore subtracting $66.5 billion from $39.1 billion has the US Fed in the red, negative net worth, to the tune of $27.4 billion.  That would make a normal entity insolvent.  The US Fed however can simply print money to overcome such annoyances if it felt the need.  But it doesn’t as it calls itself “a unique non-profit entity’’.  But what about credibility?

Former Fed Governor Kevin Warsh told Bloomberg that "a central bank with a negative net worth matters not in theory. But in practice, it runs the risk of chipping away at Fed credibility, it’s most powerful asset.’

Or IMF financial markets Chief, Tobias Adrian - “An institution with negative equity is not confidence-instilling….The perception might be quite destabilizing at some point."

This comes at a time of heightened and publicly displayed angst between this ‘independent’ body and the President.  The President is worried the Fed is prematurely and too aggressively tightening monetary policy and ruining his chances of “Making America Great Again” as viewed through the eyes of equities and property markets (not a debt burden to be worn by future generations).  It is also causing the paradox and contradiction of a central bank tightening whilst a government is stimulating the economy.  Trump is cutting taxes and spending big on infrastructure, all leading to record deficits.  To digress momentarily, it is somewhat ironic that Italy is being hauled over the coals by the EU for having a 2.4% deficit/GDP, Macron capitulating to the ‘yellow vests’ and pushing France to a 3.4% deficit whilst Trump is delivering a 4.5% deficit and no one seems worried…

Any action so unprecedented and of such a scale as the Fed’s QE program (one replicated with gusto by the EU and Japan) was always going to be prone to unintended consequences.  

QE did a number of things.  It flooded financial and property markets with cheap money boosting prices, it lowered interest rates and yields forcing people to look for alternative risk assets (and hence return) propping up emerging markets, investment bonds, junk bonds etc; and as per this final quote from that same former Governor Warsh:

“QE works predominantly through its signalling to financial markets….If Fed credibility is diminished for any reason -- by misunderstanding the state of the economy, under-estimating the power of QE’s unwind or carrying a persistent negative net worth -- QE efficacy is diminished.’’

So, whilst the Fed’s ‘insolvency’ is technically not an issue, its genesis (QE) and implications cannot be dismissed nor ignored.

Newton once proffered that “For every action, there is an equal and opposite reaction.”

We may be about to experience the opposite side of QE….